Greek debt deal won’t solve problem

At some point, possibly in the next few weeks, Europe will run into a major flaw in its plan to shore up the region’s finances: some euro zone governments, such as Greece, simply aren’t going to be able to pay their debts.

The sooner Europe’s leaders recognise this and take appropriate action, the less expensive the solution will be.

This week’s main event in Europe has been a standoff between Greece and its private creditors over the terms of a “voluntary" debt-relief deal. Agreement is crucial to avert a Greek default on a €14.4 billion ($17.8 billion) payment due on March 20, and to keep open the financing spigot from the European Union and the International Monetary Fund.

Whatever the outcome of those negotiations, though, it won’t solve Greece’s debt problem. The European Central Bank, the IMF and other official creditors aren’t taking part in the deal, so it will affect only private creditors. They hold about €200 billion of Greece’s €338 billion net government debt.

In other words, even the 50 per cent write-down Greece is seeking will reduce its debt burden by only €100 billion, or less than 30 per cent.

That’s not enough. Any country’s solvency is a function of its debt load, interest costs, growth rate and fiscal policy. In Greece’s case, assuming an interest rate of 4 per cent (the rate it may get out of the debt talks) on its remaining €238 billion in debt, and using the IMF’s projections of economic growth, the government would have to run a primary budget surplus (not counting interest payments) of 3.2 per cent of gross domestic product indefinitely just to keep its debt burden stable.

Don’t count on that happening. Greece has managed to run a primary surplus that large in only six of the past 24 years, when economic growth was much stronger. To meet such a goal now, it would have to reduce its deficit by some €10 billion a year, the equivalent of about two-thirds of its spending on social programs.

Portugal, which is not currently in line for debt relief, faces a similarly daunting task. To maintain a stable debt burden, it would have to run a primary surplus of 2 per cent of GDP, something it has done in only two of the past 16 years.

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The dire state of the two governments’ finances raises a troubling question at a time when German Chancellor
Angela Merkel
and French President
Nicolas Sarkozy
are trying to fast-track a new fiscal compact for the 17-nation euro area: How can the agreement, which seeks to toughen budgetary discipline, restore confidence in Europe’s finances if at least two of its signatories are insolvent from day one?

It’s possible that Merkel and her ideological soul mates at the ECB are hoping that, by keeping strapped governments dependent on official financing, they’ll have more power to push through austerity measures. Problem is, heavy debt loads are making the budget-cutting measures much more painful than they need to be – and probably too painful to put in place.

The likely result: slower growth, greater dependence on official creditors and bigger losses for European taxpayers down the road. Not to mention the deleterious effect the ongoing uncertainty will have on the finances of core euro zone countries, European banks and, ultimately, the ECB itself.

At any moment, doubts about the euro’s survival could trigger a financial catastrophe.

A quicker and more honest reckoning would stand a better chance of stopping the rot and creating the conditions for a successful fiscal union. We have advocated writing down the debts of Greece and Portugal by 70 per cent and 40 per cent, respectively, leaving them with the much more realistic task of achieving primary surpluses of about 1 per cent of GDP. This can be done only if official creditors take losses alongside their private counterparts. With all euro zone governments on a solvent footing, the ECB could then step in with credible guarantees to recapitalise banks and calm market jitters.

All these elements will eventually be needed if the euro is to survive. Enacting them now would dramatically increase the chances of success.